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Euroland: Lower yields – steeper curve

Mon, Mar 3 2008, 13:34 GMT
by Danske Research Team

Danske Bank A/S

Macro outlook

• • The jury is still out on the recession / no recession question in the US, but there is little doubt that the outlook remains grim and the risks of a serious slowdown are high. The US consumer is under siege, tak-ing hits left and right. Se Research USA: US: Consumers under siege for more on the US consumer.
  

• • Inflation is surging on the back of higher energy, commodity and food prices. This is eating away at dis-posable income. Employment growth has ground to a halt and unemployment is on the rise. The housing market remains in a free fall with no bottom in sight. Together with lower equities, this is causing nega-tive wealth effects. In addition, credit is being tightened and the financial crisis is far from over.

• • Working in the consumers’ favour is still a decent wage growth and lower interest rates – although the financial crisis and the tightening of credits is hampering the feed-through of lower Fed funds to con-sumers. The main source of hope for US consumption is the aggressive easing of economic policy. On top of the aggressive Fed cuts, fiscal policy is being eased by a staggering USD 152.0bn in 2008. USD 105.7bn of this will be used for tax cuts, with cheques being sent to taxpayers from May to August.
  

• • We are expecting more bad news in the coming months, with the ISM dropping below 45, weak con-sumption and a deteriorating labour market outlook. However, the massive easing of monetary and fiscal policy and hopefully a bottoming-out of the housing market will help create a modest rebound in the US in the second half of 2008.

• • The growth prospects for Euroland are deteriorating, but the outlook is much brighter than in the US. However, consumption growth was weak to begin with and is now being squeezed by high inflation. With growth in exports and investments slowing there will be no powerful growth engine left. The PMI has started a downward trend that looks set to continue. We are expecting growth prospects to continue to deteriorate throughout 2008.
  

Central banks and bond yields

• • The Fed still sees serious risk to growth and clearly has a growth focus in the current environment. With no respite in sight, in the short term more easing remains on the cards. We are forecasting 100bp more from the Fed in H1, starting with 50bp at the March meeting. We expect the Fed to be on hold in H2.

• • Yields are low and a lot of cuts from the Fed are already priced in. But as more bad news materialises and the Fed delivers, yields could fall further short term. However, 10-year yield is already at low levels historically and compared to inflation limiting the move down in US 10-year yields. As it becomes clear that the Fed is finished and the economic news becomes slightly better, yields will start to slowly edge higher again – this is expected to happen in Q2.
  

• • The EBC is caught in a dilemma between sinking growth prospects and downside risks on the one hand and high inflation with risks of second-round effects on the other. However, we continue to believe that it is a question of time before the outlook for growth becomes weak enough to justify a rate cut in spite of high inflation. The timing of the cut is tricky due to the ECB’s high inflation focus, rising commodity and food prices and the ongoing wage negotiations in Euroland. We have pencilled in June for the first of three ECB cuts this year. We are expecting lower yields in Euroland throughout the forecast period.
  

Yield curves

• • The US yield curve could steepen more very short term. However, the US yield curve may flatten some-what again when the Fed stops and growth prospects improve. The yield curve in Euroland will steepen through 2008 as the ECB cuts rates and growth prospects deteriorate.

Country spread

• • The divergence in the monetary policy response will dictate the relative performance. The US may out-perform Euroland in the short term as the Fed cuts rates further, while the ECB remains reluctant to act. However, this will begin to change in Q2. Easing will probably be done in the US in June, while the ECB will be on the verge of starting if it has not done so already.

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Published on  Mon, Mar 3 2008, 13:45 GMT